Saturday, September 17, 2011

In an earlier post I covered why the US Federal government should never run a budget surplus, unless there is an offsetting trade surplus. And given that the US runs a large trade deficit, a budget surplus would indeed be harmful. Let me address this topic again in the simplest possible terms. For more details and policy proposals and spending constraints see the original post.

The thing to remember throughout is that a sovereign currency issuer like the US, doesn't face a solvency constraint, i.e: we are not going to run out of dollars. The constraint for government spending is not solvency but inflation. This is covered more in the earlier post.

Why not a budget surplus?

If I give you $20, and you give me $15, you are now financially wealthier by $5, everyone can agree on that. It doesn't matter whether a real good/service was bought/sold or not, as far as financial assets (such as cash, deposits etc:) are concerned, the outcome is the same, you are financially wealthier by $5. If that one transaction is all that you engage in for a given year, you can think of the $15 as your spending for the year, while the $20 is your gross income. Your income less spending is $5. Obviously, your financial position is better off (by $5) at the end of the year. The same also holds true at the macro level, let us take a look at government budget deficits/surpluses to demonstrate this.

We obviously have a budget deficit when the federal government spends more than it taxes. Let us say taxes are $2 Trillion, while government spending is $3.5T, then the government deficit is $1.5T. So where does this extra $1.5T go, does it disappear into thin air as some believe? For simplicity, if we assume for now, the foreign trade balance is 0 (exports equals imports), then every single one of those government deficit dollars ends up in the domestic private sector.In other words the government budget deficit, to the penny, can be thought of as net income for the domestic private sector as a whole.

The deficit spending may be income for an additional federal govt. employee. It may be an additional firefighter or teacher's salary, via a transfer to a state government. It may be income for a private construction worker hired to repair the nation's ailing bridges. It may be retained earnings for a business which provides services to the government. It may be dividends to the investors of that business. It maybe in the form of a tax cut for lower income folks. Or it maybe even wasted on bank bailouts.[1]

Given that inflow is larger than outflow by $1.5T, domestic private sector net financial wealth (financial assets minus debts) as a whole rises by $1.5T.[2] This is not rocket science, it is no different than if I give you $20, and you give me $15, you are now financially wealthier by $5. Similarly, when the government spends $1.5 trillion on top of what it takes out in taxes, domestic private sector net financial wealth (as a whole) rises by $1.5T. Where else can the money ago? To the residents of planet Vulcan? Any spending within the private sector just transfers
financial wealth within the sector. If you buy a $500 Dell computer,
you are financially poorer by $500, while Dell, its employees, investors, suppliers etc: are financially richer by $500. Total private sector net financial wealth has not changed. It just moved within the private sector.

Guess what happens when the government runs a budget surplus. Let us say taxes are $3 Trillion, while government spending is $2.5T, then the budget surplus is $500 Billion. In our example this would be like if I give you $20, and you give me $25, you are now financially poorer by $5. The government is literally taking more out of the domestic sector than it is putting back in. A $500B subtraction to private sector net financial wealth (as a whole). If the budget surplus continues for an extended period, the private sector is literally being depleted.

This is unsustainable. In the entire history of the US there were only 5 periods in which we had 5+ years of government budget surpluses. As economist Randall Wray points out, each one was followed by a depression. The last extended surplus years were 1920-29, where we reduced government debt by 33%. Guess what followed, the Great Depression. Am I saying that the budget surplus was the cause of the depression? No, but it certainly doesn't help, as the private sector would be net borrowing (in deficit) if it is to keep up the same level of spending, when the government budget is in surplus. Actually, it is far more likely that the causation is reverse, a private debt binge is reflected in the government budget as a surplus.[3] The point is that sectors always balance. If the private sector does decide to reduce its debt fueled spending (which is bound to happen eventually), then GDP falls, given that GDP is total spending. As a consequence total income falls due to the fact the someone's spending is someone else's income. And now we have a recession.

On a quick note, I often hear people say, what about government debt issuance? Isn't that a flow out of the private sector, that balances the deficit inflow? Then I say, are you saying buying $100K of treasuries decreases your net financial wealth by $100K? No of course not, it is a financial asset swap. If you move your money from a checking account to a bank CD does your total financial assets fall? Buying a treasury is just like buying a CD, it is in you asset column. Your net financial wealth hasn't changed, only the composition of your asset portfolio has changed.

For those who are not familiar with the term Current Account, it is mostly the foreign trade balance (exports - imports). It also consists of net factor income. For more details on terms see here. The domestic private sector consists of households, firms and financial firms and its balance is the addition/subtraction to net financial wealth of the private sector in a given period. If the private sector is net borrowing (in deficit), then its balance will be negative; if it is net saving (in surplus), then its balance will be positive.

Economist Scott Fullwiler has compiled actual financial balances of each sector from US national accounts. See figure below. See here for actual examples from US national accounts- see footnotes 1, 3 and 5 in that post for source data. Notice the formula always holds true. Notice how during the late 90s as the government runs a budget surplus and the current account is in deficit (negative), the private sector balance (as a whole) is in deficit for the first time. The same happens during much of the 2000s as the government budget deficit was not large enough to offset the large current account deficit.[3] A private sector deficit is a subtraction to private sector net financial wealth.

Fig 1: US Sectoral Financial Balances (from Scott Fullwiler)
Note: the red line in the chart is shown as positive since the label is Govt. deficit (i.e: negative Govt. balance)

Why does this hold?

For an explanation see economist Stephanie Kelton's article here and here. For an advanced version see this article by economist Scott Fullwiler. For the general reader, I will use a simple example to illustrate this. This is not an explanation, just an illustration...

Let us say we have 3 people Alice, Jim and Bob. Each starts out with net financial wealth of $500. Note the keyword NET, Jim may have $2000 of financial assets, and debt of $1500, in which case his net financial wealth is still $500. Also note the keyword FINANCIAL we are only referring to financial assets (such as cash, deposits, stocks etc:). Real assets (such as houses, cars etc:) are not included in the calculation. They engage in 3 transactions during a period of time...

Transaction 1: Alice buys eggs from Jim for $10. Obviously now Alice is down $10, while Jim is up $10. The sum of the balances is ZERO. This is just a fancy way of saying if Alice gives Jim $10, then Alice doesn't have $10 anymore. Alice's net financial wealth falls by $10, while Jim's rises by $10. The total net financial wealth of the system ($1500) hasn't changed as we would expect, given that sum of the balances is zero. $10 of financial wealth transferred from Alice to Jim.Transaction 2: Bob buys bread from Alice for $20. Bob, now is down $20 (his balance is in deficit), while Alice's balance which was in in deficit of $10 after transaction 1, is up $20, so now she has a surplus of $10. Jim's balance remains at a surplus of $10. Once again the sum of the balances of all three is ZERO, not exactly rocket science here.Transaction 3: Jim buys plumbing service from Bob for $40. Yup still ZERO.

Fig 2: Financial Balances

After 3 transactions, Alice and Bob now have a positive balance (surplus) of $10 and $20 respectively, while Jim has a negative balance (deficit) of the exact same amount as the total surplus in the system $30. For any single entity to run a surplus, the sum total of the rest in the system must run a deficit of the same amount. In other words the balances always sum to ZERO, after each transaction, and you can see that in the 'total' column for each row. The total financial net wealth never changes, it still remains $1500. Ever wonder why we have double-entry accounting? For every credit, there must be an equal debit somewhere else, for balances to sum to zero. Anyway in our example...

Alice Bal + Bob Bal + Jim Bal = 0

Now try this same exercise with 50 people, the sum of the balances for all entities after any given period must equal ZERO. Now try this with groups of people, say 3 corporations, it still works. We are just dealing with millions of dollars now. Now let us form three all encompassing groups. The government sector, the private sector and the foreign sector. This still holds, and real world data confirms the prediction.

Government Bal + Private Sector Bal + Foreign Sector Bal = 0

Private Sector Bal = -Government Bal - Foreign Sector Bal

If the foreign sector has a surplus, that is the same as a current account deficit from our perspective, so negative foreign sector balance, is positive current account balance. And obviously negative government balance is the same as the government deficit.

Private Sector Bal = Government Deficit + Current Account Bal

Update: The main difference is that Alice, Jim and Bob cannot create new dollars when they spend. The US government as the sovereign issuer of the dollar, creates new dollars when it deficit spends. It can run perpetual deficits, and it has in the past. In the entire history of the US there has only been 5 periods, where we had 5+ continuous years of government budget surpluses. From 1946 to 1981 when we reduced the debt/GDP from 121% to 32%, guess how many surplus years we had? Just 5 surplus (barely) years in total. As you can see in Fig 1, the red line rarely crosses into positive territory. Solvency is not a constraint for currency issuers, inflation is the only constraint.

Conclusions

The sum of sectoral financial balances always equal ZERO. If the government runs a budget surplus, without an offsetting current account surplus, then the private sector as a whole is running a deficit, i.e they are net borrowing and hence this is a subtraction to their net financial wealth. A surplus of one sector must result in a deficit for another.

So when the private sector attempts to net save (run a surplus) as in the current recession, the federal government should be accommodating and run an appropriate budget deficit. Some of this will happen naturally due to reduced tax revenues and increase in the automatic stabilizers (such as unemployment insurance). Any attempts at fiscal austerity (trying to balance the budget) while the private sector wishes to save will not end well. Two sectors cannot net save at the same time (depending on the foreign sector balance of course) as sectoral financials have to balance.

If both sectors attempt to net save, that is if the government doesn't pick up the slack for loss of private sector spending, there is obviously now less spending overall in the economy (saving is defined as not spending in economics). Less spending means GDP falls, and as a consequence income falls and the recession worsens. And of course now the sectors balance at a lower GDP level. Since income falls, taxes fall and ironically the government deficit actually gets worse, when the budget cuts are attempted. This is what we are seeing with Ireland and Greece.

The sectoral financial balances model is not rocket science, it is not any more complicated then if I give you $20, then I don't have $20, you have it. What applies for individuals also applies to sectors also. But yet this still has not made much inroads into mainstream economics, although that is slowly changing now. The experiences of countries like Ireland and Greece shows the prescription of mainstream economics, government fiscal austerity, is downright disastrous. Just in Q2 2011 Greece's GDP was falling at an annualized rate of 7.0%. The last chart shows that the government budget cuts starting in 2010 have been the biggest drag on GDP. But yet the calls for budget cuts continue in the Eurozone officialdom. Unless this course is reversed this is unlikely to end well.

Not a single person running our government seems to understand this basic fact as well. The airwaves are saturated with talk about balancing the government budget, when it is not even close to being an issue. It is not even necessary to run a budget surplus to reduce our debt to GDP ratio. The real issue is excessive private debt. When was the last time we heard about that from the congressional talking heads. We hear talk about balancing the budget from even the most liberal faction of Congress (although to be fair, at least they are talking about balancing down the road not in the middle of the recession).[4]. Running an economy based on faith based beliefs, rather than facts is bound to be disastrous.

Updated 9/21/2011: Reorganized things a bit
Updated 3/20/2012: Moved some notes up to the article
Update 4/9/2012: Fixed broken links,fixed some errors

Notes

1. Not all government deficit spending is created equally. Some are more efficient than others. A bank bailout is one of the most inefficient way of spending government resources. 2. Note the key word financial we are only talking about financial assets (such as cash, checking deposits, stocks etc:) in the above examples. Real assets (such as houses, cars etc:) are not included. Financial transactions are a ZERO sum game from a global perspective for users of a currency, that is what we are trying to show here. 3. Or the causation maybe that the private sector gets itself into debt, the sectors balance and the government budget is in surplus, that is more likely. Either way the sectors always balance. The private sector could have chosen to reduce its debt fueled spending, and if another sector doesn't pick up the slack, then GDP falls and the sectors balance at a lower level of GDP, but that is not what happened (except for the 2000 recession). This is what is happening now, the private sector is trying to pare it is debt burden. While the government did pick up some slack, it was only enough for a small growth in GDP. Which, by the way is fading as the government cuts its budget. 4. Update 9/19: 30% of the deficit is due to the recession alone, given that there is less tax revenue and more social safety net spending. The best way to cut the deficit ($4T in 10 yrs) is to do nothing at all with the deficit, get to full employment as fast as possible. But if you must cut it now, best to do it it in a way that impacts the least amount of spending. For example, richer people save rather than spend much of their income, so raising their taxes is less likely to impact GDP that much.

Tuesday, September 6, 2011

You hear this a lot these days from deficit hawks. Our current government deficit spending, will result in a higher future tax burden. So better cut back on the debt now, for the sake of our grandchildren. It is as if these people forget how fractions work - Debt/GDP. Debt by itself means nothing, it only has meaning as a percentage of income. Remember that, US GDP equals all gross domestic income made in the US, given that someone's spending is someone else's income. Thus US debt/US GDP is the relevant figure here. It is as if the hawks assume the denominator (income) will be static forever. Only if GDP is static. What is really static over time is the numerator - debt principal and interest payments. As GDP and inflation grows over time, the original debt remains the same, that is a certainty. So what happens when GDP is higher, income will also be higher (since GDP is income) and thus tax payments will also be higher, all without any new tax increases[1]. So even by their misguided logic, you will have more taxes to cover the same debt (which never changes over time), plus more for new debt issuance. Is there a need for an increased tax burden, in this scenario?

US Debt/GDP history

Take a look at the experience of the US after WWII (1946-1981). Debt/GDP ratio was 121% in 1946, but by 1981 it was just 32%. You would think the Government paid down a lot of its debt. In reality not one cent was paid off. It quadrupled from $271B to $994B. Its not like the government stopped issuing debt after 1946. But yet the debt/GDP ratio went down, because GDP growth far outstripped debt growth. Yet during the same period, the tax burden remained roughly the same, averaging around 17-18% of income (GDP). This idea that the US government is just like a household has to be jettisoned for good. The government does not need to ever repay its debt, it outgrows it. It has only been paid back once (in 1837), but then a depression followed and the government has been in debt ever since. How many households can do that and still function? Does it really matter (even by conventional logic) that the government debt is $100T 30 years from now, when GDP is $200T?

You know what really hurts your grand children. Its not US debt, it is austerity (lack of GDP growth, due to government budget cuts). Generally a recession happens when consumer spending (C) and private investment (I) falls due to loss of confidence in the economy, in this case due to the collapse of the housing bubble. As C and I are components of GDP, GDP falls, and income falls as as a consequence. Less income among the same number of people, and guess what, some people finds themselves out of work[2]. Government spending (G), which is also a component of GDP should rise to prevent a collapse in GDP. Thus, government debt will also rise. Some of this increased spending happens automatically, as social safety net spending increases (unemployment insurance, social security etc:). This may not be enough, ideally the increase should compensate for the loss in C and I[3]. Yes the numerator (debt) increases rapidly for sometime, but GDP growth catches up far faster than if we had chosen the austerity path. Austerity is a double whammy. When the government cuts spending (G) in a recession, not only does GDP fall, but ironically the debt also rises . Why, because GDP is income, and when income falls, taxes fall, unemployment insurance payments rise, thus actually increasing the government debt. The experience of countries like Ireland who embraced austerity early on should show that trying to cut government debt in a recession actually increases the debt. Looks like the US is slowly heading in the Irish direction.

So far I explored this with mainstream logic. The mainstream assumption is that taxes fund government spending. In the case of a state government yes, in the case of a national government under the Euro regime, yes. But for a sovereign issuer of currency, under a floating exchange regime, no. Why does the issuer of dollars, who can create them at will, need to acquire dollars to make payments in dollars? In this type of government (US, Japan, Canada etc:) taxes are a form of inflation control[4], not government income. Yes currently there are restrictions on how the government spends, but they are a self imposed political straight jacket, they are certainly not economic in nature. They should be repealed so we can unleash the full potential of our economy. The title claim makes even less sense, when you take this into context. The only real economic restriction on government spending is inflation.[5] Plus lets us not forget that a liability (government debt), is in an asset to some one else. 69% of US government debt is owned by American households and institutions. If you own treasuries they are your assets not your debt. So if anything your grand children are inheriting interest paying assets not debt.

Notes:

1. I made things a little simpler so it is easy to follow. See the Question 5 section here for more detail, on why government budget surpluses are not needed to reduce the debt ratio. 2. Again I simplified things slightly. For more detail on recessions see here.3. Not all government spending is created equal. Some spending is very inefficient, such as tax cuts for rich, or giving tax cuts to business and hope they hire people. On the other hand direct government spending on creating jobs is far more efficient. While the modest US stimulus of 2009 did help in GDP growth when it was still active, it didn't help as much (it still helped) in lowering the unemployment situation. It was far too small and contained too much inefficient spending. Direct government spending on jobs has not been tried since the 1930s when it was highly successful. The GDP growth rate then, averaged 10% and employment growth was 750k jobs/month (population adjusted). 4. In this example I am referring to possible inflation due to government deficit spending. There are different types of inflation. For example supply issues, caused by real shortages or speculation. The latter type of inflation is what is occurring now in the energy and food markets.5. There is a range beyond which government spending will cause more than the desired inflation. This range is much wider in recessionary times, while it is much narrower at times of full employment. But in no way is the money supply proportional to price inflation. It maybe during times of full employment, but otherwise unlikely.